The flight from quality continued to play out in May as the Treasury
Index was down again. This time the index lost 1.0% for the month. Thus far, March has been the only positive month for the index in 2009. Pressure is coming from a couple of different angles. Domestic investors, sensing an economic rebound, are less interested in the credit-safety of Treasury debt - the flight to quality trade is coming off. This is occurring as the credit market gets back to pre-Lehman default levels in some areas (TED spread) and more normalized trading patterns. Investors are clearly favoring some risk, and for many of them that means credit. Also making it more difficult for Treasuries is the considerable size of the supply calendar which continues unabated. Pressure is also coming from abroad. Led by China (~$768B), other nations, hold an awful lot of Treasury debt. In the case of China, they are known to have been net buyers recently; however they are shortening up on duration by selling longer-dated bonds and buying in the one year or shorter range. Overall, foreigners still have demand for the liquidity that Treasuries offer.
The benchmark 10-year Treasury note lost 2.7% in May and now has a YTD
loss of 8.5%. The 30-year bond lost 4.5% in May and is down 23.9% YTD.
Could the "Aaa" credit rating of the United States be in jeopardy? Do we deserve such a high rating? The answer, of course, depends on whom you ask. Right now the opinion that matters most is that of the raters. Moody's says the rating is stable and "supported by a diverse and resilient economy, strong government institutions, high per capita income and a central position in the global economy."
The stability of the country's credit rating has been debated for years, but there are a few reasons why this topic made headlines this past month. One very well known fund manager raised the prospect of such a downgrade as a result of all of the debt the current administration is layering on. There was also news that the U. K. had their outlook revised to "negative" from "stable" by another rater - Standard and Poor's. Usually an outlook change precedes an actual change in the credit rating, but does not necessarily mean that a change is imminent. The basis for the outlook revision is the increasing national debt levels in the U.K. We can be accused of doing the same here, but the U.K.'s debt level represents a higher percentage of that country's GDP. As for Moody's view of the U.S., they are clear that a reassessment is always a possibility. From my perspective, Treasuries remain a risk-free asset class - that is, free of credit concerns. Market risk on the other hand, remains, and I continue to view them as over-valued.
The market was firmly braced for the third biggest bankruptcy filing in
U.S. history when General Motors filed for protection from creditors on
June 1st. GM is now third in a dubious line behind Lehman Brothers and
WorldCom in terms of the dollar value of companies that have failed. GM's demise has been playing out for years as competition, legacy costs, the high price of gasoline, tight credit, and the weakened economy proved to be too much for the company to overcome. For several years we have heard about the company's lack of profitability and cash burn rate - said to be in excess of $1B per month. With that kind of business operation, it is little wonder why the company finds itself in the position it is in today - about 60% owned by the government and renegotiating with creditors in a struggle to survive.
It wasn't always this way, of course. Prior to 1981 GM was a "AAA"-rated company by S&P. Then the downward trajectory in its rating began and now ends with GM at "D" - as in default. GM lost its investment grade rating in May 2005 when it was cut to "BB." Bondholders did have time to decide what course of action to take after GM was cut to a speculative-grade (junk) rating prior to the eventual bankruptcy filing. Some of the longer bonds (8.375% '33) continued to trade in the high 80s to mid 90s (cents on the dollar) years after it was no longer investment-grade-rated. Obviously investors thought the prospects for the company looked better at the time and that the company could turn things around. In the last few trading days before the filing, bonds were trading anywhere between 5¢ and 11¢.
I fully understand the desire of many bondholders who held on in hopes
of a better outcome. There was (and remains) a lot of resistance to
the deal that is being worked out in regard to the debt-for-equity
swap. I have read commentaries where auto company bondholders are portrayed
in less than favorable terms for trying to position themselves (some
would say holding out) for a better outcome on their investment. Many
large position holders would have preferred to take their chances in
bankruptcy court and I can certainly empathize with them. There is,
after all, a capital structure and a pecking order that has worked
for bond investors for a long time. The economic disruption that a
long and protracted bankruptcy process and liquidation of the company
would cause is part of the other side of the argument. As we have read,
it is not just the auto companies themselves that would be harmed.
It is also about the parts and suppliers industry, the dealers, and
the regional social distress that would result.
As far as making an investment now in GM's bonds is concerned, it is not something I would recommend. We have always felt that junk bond investors are better served by making an investment in a high-yield bond fund rather than selecting the individual bonds.
One final note on the auto industry relates to Ford. In late May,
the finance arm of Ford (Ford Motor Credit) raised $1.1B in a new debt
offering. The bonds carry an 8% coupon rate and originally sold at
a substantial discounted dollar price of 82. The yield at that level
is 13%. As you can probably guess by the yield, these bonds are not
very highly rated. Ford Motor Credit's outstanding debt is rated "CCC+." As
I cautioned last month - caveat emptor.
| Barclays
Fixed Income Index Returns Through 5/31/09 |
| |
Duration |
May |
YTD '09 |
Ret.
'08
|
Ret.
'07 |
Ret.
'06 |
Ret.
'05 |
| US T Bill Index |
0.31 |
0.02 |
% |
0.12 |
% |
2.44 |
% |
5.01 |
% |
4.82 |
% |
3.05 |
% |
| US Treasury Index |
5.22 |
-1.01 |
|
-4.10 |
|
13.74 |
|
9.01 |
|
3.08 |
|
2.79 |
|
| US TIPS Index |
5.82 |
2.10 |
|
5.73 |
|
-2.35 |
|
11.63 |
|
0.41 |
|
2.84 |
|
| US Aggregate Bond Index |
4.14 |
0.73 |
|
1.32 |
|
5.24 |
|
6.97 |
|
4.33 |
|
2.43 |
|
| US Govt/Credit Index |
5.18 |
0.80 |
|
-0.30 |
|
5.70 |
|
7.23 |
|
3.78 |
|
2.37 |
|
| US Credit Index {A2} |
5.91 |
3.38 |
|
4.34 |
|
-3.08 |
|
5.11 |
|
4.26 |
|
1.96 |
|
| US High Yield Index {B1} |
4.34 |
6.73 |
|
26.80 |
|
-26.16 |
|
1.87 |
|
11.85 |
|
2.74 |
|
| Caa Component |
3.74 |
10.50 |
|
38.04 |
|
-44.35 |
|
-0.13 |
|
17.66 |
|
0.64 |
|
| Emerging Mkt ($$) {BA1} |
6.08
|
4.53 |
|
15.64 |
|
-14.75 |
|
5.21 |
|
9.96 |
|
12.27 |
|
| Municipal Index |
8.34 |
1.06 |
|
7.43 |
|
-2.47 |
|
3.36 |
|
4.84 |
|
3.51 |
|
| Municipal Index - 5 Year |
4.00 |
-0.07 |
|
3.19 |
|
5.78 |
|
5.15 |
|
3.34 |
|
0.95 |
|
| Prepared by Christopher Keith Fixed Income Manager |
Christopher Keith
Fixed-Income Manager
|
